Nonprofit Capital: a Review of Problems and Strategies / Prepared by William P

Nonprofit Capital A Review of Problems and Strategies

Library of Congress Cataloging-in-Publication Data

Ryan, William P. Nonprofit capital: a review of problems and strategies / prepared by William P. Ryan / for Fannie Mae Foundation [and] The Rockefeller Foundation. p. cm. 1. Nonprofit organizations — Capitalization. 2. Charities — Capitalization. I. Fannie Mae Foundation. II. Rockefeller Foundation. III. Title.

361.763 2 2001117609

ISBN 0-89184-055-9

Nonprofit Capital A Review of Problems and Strategies

prepared by William P. Ryan for The Rockefeller Foundation and Fannie Mae Foundation Author’s Note/iv Nonprofit Capital: A Review of Problems and Strategies

I am grateful to the many people who agreed to be interviewed for this paper; their examples, arguments and insights form the core of this work. Jane Preston, a consultant to nonprofits and a fellow at the Hauser Center for Nonprofit Organizations at Harvard University, provided invaluable research assistance. Mike Sviridoff contributed critically important leads, ideas and feedback throughout. Ed Skloot and Vince Stehle of the Surdna Foundation also helped in shaping the paper and offered useful leads and input.

—William P.Ryan April 2001 Nonprofit Capital: A Review of Problems and Strategies Contents /v

Contents EXECUTIVE SUMMARY 1 INTRODUCTION AND BACKGROUND 3

1. KEY THEMES 5

2. DEFINING NONPROFIT CAPITAL AND ITS BENEFITS 7 Facilities Capital 8 Working Capital 9 Permanent Capital 11

3. STRATEGIES AND SOLUTIONS FOR NONPROFIT CAPITAL PROBLEMS 13 1: Reforming the Nonprofit Capital Market 14 Reducing Transaction and Opportunity Costs Improving Foundation Leverage Encouraging More Philanthropy With Better Information for Donors 2: Reforming Philanthropy 16 High-Engagement Grantmaking Proprietary Intermediaries Stabilization Funds Philanthropic Tax Credits Program Related Investments 3: Reforming Nonprofits 20 Become Bankable Generate Working Capital Internally Become Self-Sufficient, or Create Social Enterprises Grow Nonprofits Convert to For-Profit Status 4: Expanding Access to Private Capital Markets 26 Institutional Strategies Technical Innovation Public Policy Strategies Social Investment Strategies

4. CONCLUDING REFLECTIONS 39

RELATED READINGS 41 INTERVIEWS 46 ENDNOTES 47

Nonprofit Capital: A Review of Problems and Strategies Executive Summary /1

HIS PAPER WASPREPARED TO HELP the Fannie Mae and Rockefeller Executive Foundations review the challenges and opportunities nonprofit organiza- Summary Ttions face in attempting to meet their need for financial capital, particularly in the areas of community and work-force development. Based on interviews and a literature review, the paper presents a summary of notable strategies and practices.

Key Themes. Those interviewed for the scan are generally optimistic, in large part because nonprofits are more inclined and competent than ever to deal with finance and management issues, but they still find that working capital is the hardest to raise. Most feel that performance and capital are inseparable, and that simply supplying more capital — without attention to how it is invested — is not enough.

Defining Nonprofit Capital and Its Benefits. Observers make two sets of distinctions in analyzing the capital problem and its solutions:

Three types of capital meet different needs and have generated different strategies:

➤ facilities capital funds the building or acquisition of offices and facilities; ➤ working capital covers expenses during low cash flow and funds strategic investments in an organization’s capacity; and ➤ permanent capital refers both to endowments and to the capital reserves that community development organizations use to invest in housing and business development.

The purported benefits of capital all center on improving productivity — especially compelling in today’s environment, where:

➤ expensive information technology is believed to be essential to enhanced efficiency; ➤ an emerging organizational effectiveness movement stresses investment of working capital in management processes; and ➤ capital can be a competitive asset that might not produce better program outcomes but could enable the organization to survive when faced with larger, better-capitalized competitors.

Strategies and Solutions. The nonprofit capital solutions that were cited most often in the literature and interviews represent four strategies for dealing with capital challenges:

Reforming the Nonprofit Capital Market — Some analysts envision a more rational, segmented, and therefore more efficient and responsive, nonprofit capital market, which would create the time and incentives for nonprofit managers to improve their organizations. Executive Summary/2 Nonprofit Capital: A Review of Problems and Strategies

Examples of this include: reducing transaction and opportunity costs; improving foundation leverage; and encouraging more philanthropy with better information for donors.

Reforming Philanthropy — Some argue for making grants function more like working capital that nonprofits can use to improve their capacity and performance, and less like revenues that fund direct service provision. Examples of this strategy include: high-engagement grantmaking (including the much discussed idea of venture philanthropy) in which funders add value and ensure accountability by becoming more involved in grantees’ work; proprietary intermediaries, which focus on building the capacity of a chosen few nonprofits, instead of an entire field; stabilization funds, which build capital reserves and financial management capacity; philanthropic tax credits, which promote larger, longer term grants, and management assistance, from corporate donors; and program related investments, which are often credited with sharpening the focus on results.

Reforming Nonprofits — Others argue that nonprofits can generate their own working capital by: operating more efficiently; learning to use debt more aggres- sively; or by earning unrestricted income in the marketplace, although the latter may be built on widespread but dubious assumptions that public and philanthropic funds are shrinking. Examples of nonprofit reform strategies include: making nonprofits bankable; generating working capital internally, primarily through better pricing of services; creating self-sufficient nonprofits or social enterprises; growing nonprofits; and converting to for-profit status.

Expanding Access to Private Capital — The big prize for a growing field of analysts, innovators and policymakers is access to the private capital market, a prospect that has inspired a variety of innovations aimed at supplying permanent capital for community development projects.

➤ Institutional strategies to access private capital focus on creating the infrastructure for community investment by funding and strengthening a wide array of community development financial institutions (CDFIs). ➤ Technical innovations for accessing the private capital markets include the use of tax-exempt bonds (generally for facilities); net-lease finance (in which nonprofits convert real estate into capital by selling it and leasing it back); and secondary markets to replenish the capital supplies of CDFIs. ➤ Public policy uses tax credits to encourage lending to and investment in CDFIs. ➤ Social investment strategies attempt to cultivate socially motivated investors, both individual and institutional, often willing to accept low returns as a trade-off for capitalizing social ventures. Nonprofit Capital: A Review of Problems and Strategies Introduction /3

his paper was commissioned by the Fannie Mae and Rockefeller Introduction Foundations to review current practices and thinking on how to meet and Tnonprofit organizations’ need for financial capital. Both foundations, joined by the Surdna Foundation, wanted a map of this vast, sometimes techni- Background cally complex landscape to aid in their own analysis and strategy development. The paper is based on interviews (with nonprofit managers, consultants, researchers and bankers) and a review of the literature, highlights of which are summarized under “Related Reading.” The interviews were open-ended discus- sions aimed at identifying both new and important practices and the underlying assumptions that shaped them. The interviewees cited dozens of practices and strategies in use across the nonprofit sector. But the paper gives special attention to those that grow out of or may be most relevant to two program areas of special interest to the foundations: community development and work-force development. The final result of this exercise is in fact much like a map. The paper attempts to provide an overview that might help decision makers better understand their options. So while it does not pretend to be a technical manual that readers can use, for example, to learn how to issue tax-exempt bonds, it does provide a context for considering the potential of tax-exempt bonds. It could help in thinking about some key questions: What kind of capital will a given approach generate? What can nonprofits accomplish with that capital? What are the alternatives? How else can we think about the problems of capital? The paper has four parts. Part one sketches a few cross-cutting key themes that emerged from the interviews and literature review. Part two defines nonprofit capital, and the problems that various types of capital attempt to solve. Part three — the bulk of the paper — reviews the strategies and solutions offered in response to nonprofit capital problems, organized into categories that highlight the strategies that shape them. Part four is devoted to brief concluding reflections. Following that is an annotated bibliography of some notable books and articles on capital issues.

Key Themes /5 Key Themes 1

HE OBSERVERS INTERVIEWED FOR THIS PAPER and reflected in the literature approach nonprofit capital questions from very different angles. Yet Tthree themes emerged so consistently they are worth noting at the outset: Observers are generally optimistic. While many were eloquent in describing barriers and frustrations they face, most observers described important shifts in attitude, practice and opportunity that they felt were already enabling real progress in meeting nonprofit capital needs. Observers did almost universally describe a culture marked by nonprofit ignorance of, and indifference to, finance issues, and to funders who were often as much part of the problem as the solution. But most suggested that attitudes and technical competence had improved markedly in recent years, creating yet more opportunities for progress. Working capital presents the biggest challenge. As the paper makes clear in many cases, working capital, which enables nonprofits to invest in their own capacity, is critically important and generally difficult to come by. Even nonprofits that are part of the community development financial infrastructure — dedicated to providing capital for economic development — find that they themselves are in need of working capital. Performance and capital are inseparable. Nonprofits need capital to perform, yet no one wants to provide capital to a nonprofit that is not capable of performing. This conundrum has profoundly shaped many of the responses to capital challenges. It may account for the general scarcity of philanthropic working capital, and it surely explains the emergence of several new approaches that stress accountability for performance as a condition of capital investment. Several observers even argued that providing too much working capital from external sources could be a problem, not a solution: nonprofits might “hide behind the capital,” using it to compensate for poor performance, not for investing in better performance.

Before getting to the strategies that raise these themes, a review of the meaning and purposes of nonprofit capital is necessary.

Defining Capital /7 Defining Nonprofit Capital and Its Benefits 2

HE DISCUSSION IN THIS SECTION defines several types of capital, their functions and their benefits. More than an exercise meant to clarify Tterms, it is an important part of the mapping of nonprofit capital development because it helps answer several fundamental questions:

What is the nature of the nonprofit sector’s capital problem? Is that problem different today — more complex or more urgent — than in previous years? What do we gain by solving by it, and by trying to solve it now?

The following types of capital are treated in this discussion: Facilities Capital. Facilities Capital funds the building or acquisition of real estate to house nonprofit offices and programs. Although observers argue that the process of raising facilities capital can be an excellent opportunity to address a nonprofit’s long- range strategic and financial goals, many nonprofit managers mistakenly conclude that once they have a facility, it will generate a sustainable flow of revenue by attracting more program participants. Working Capital. Working Capital is the most sought after and most scarce type of capital for most nonprofits. It can fund routine expenses during periods of low cash flow or more strategic investments in an organization’s capacity to grow or improve its services. Since many funders find it risky to invest in an organization they do not control, they may make working capital available through more hands-on grantmaking that gives them the opportunity to ensure the capital is used productively. Permanent Capital. Permanent Capital refers both to funds granted for an organization’s endow- ment and to the capital reserves that community development organizations use to invest in housing and business development. While the capital development pools of many community development financial institutions have been expanded, the permanent capital in these pools is to be passed through as investments in the community, and does not necessarily supply working capital to the nonprofit making those investments.

The following discussion of these types of capital will provide a context for the later review of strategies and solutions aimed at addressing capital problems. Facilities Capital /8 Defining Nonprofit Capital and Its Benefits

Facilities Capital As a substitute for building better organizations. Other analysts argue that making more NO ONE CONTESTS THE IDEA that capital made facilities capital available — in the absence of available for acquisition or improvement of facili- comprehensive financial planning and strategy ties for a nonprofit will produce better-housed development — can do more harm than good. organizations. That is why facilities funds — According to Clara Miller, president of the most notably for arts and cultural organizations Nonprofit Finance Fund, nonprofits often look and, more recently, child-care operators and at facilities questions in isolation from business human service organizations — have found such planning and strategy development. In these a useful niche. Observers do differ, however, cases, she says, facilities capital can be “an alba- on the more far-reaching effects of facilities tross,” encouraging nonprofits to “take on a build- funding. Can it strengthen an organization’s ing that’s too big without looking at the business broader fiscal and organizational capacities? Or inside. Instead of getting security and equity, they does it distract weak organizations from develop- get debt service and maintenance obligations that ing those other capacities? they underestimated.” The Nonprofit Finance Fund’s recently As a platform for building better organizations. launched Building for the Future program helps Nonprofits that buy and manage their own facili- nonprofits cope with these sometimes overwhelm- ties are sometimes imagined to get the same ing obligations. As the feasibility study for the new benefits as households that move from renting program found, facilities ownership does not nec- to homeownership: more security, the ability to essarily beget good programs or better-managed develop equity and more sophistication for manag- organizations. Reviewing the situation of a sample ing all of their financial affairs. of Boys and Girls Clubs in the northeast United Carl Sussman, a nonprofit consultant and oper- States, the Fund discovered that “the best-attended ator of a child-care facilities fund, argues for these Clubs generally had the highest number of perma- benefits in a recent paper reviewing the prospects nent staff, indicating that dedicated leaders (not for nonprofit facilities funds: square footage) attract young people…Square footage attracts neither members nor money.” And Facilities loan funds often stimulate broader sys- those who regard facility ownership as a potential temic changes that affect operating income and cash cow (generating revenue from facility rentals, the willingness of providers to assume debt, for example) tend not to invest in facilities mainte- leverage new sources of capital and in other ways nance. Clubs generating the highest percentage of stimulate higher levels of capital investments in their revenues from building-driven activities are community-based child and family support facili- the very ones that “spend the least on their build- ties. These are the indirect benefits of a specialized ings per square foot.” 2 facilities loan program.1 As with the Boys and Girls Clubs, so with arts and cultural groups, and even with community More capital for facilities, according to this development corporations (CDCs): it can be easier logic, will produce not only better-housed non- to acquire or develop facilities than it can be to profits, but better-run nonprofits as well. manage them effectively over time. Defining Nonprofit Capital and Its Benefits Working Capital /9

Working Capital that “nonprofits with working capital have more choices, more staying power and are more likely WORKING CAPITAL ENABLES AN ORGANIZATION to to strengthen organizational capacity.” 3 Economists make strategic investments in its own capacity: to make the same argument slightly differently: develop new programs; conduct research; evaluate because of “ ‘diminishing returns to production,’ at its work; engage in planning and analysis; upgrade some point, without the addition of further units technology; support staff or board development; of capital, adding one more unit of labor leads to a and expand the organization. Not surprisingly, it negative increase in a firm’s output. At that point, emerges as the most important type of capital a firm cannot produce additional units of goods from this scan: it is the most sought after by non- or services without additional infusions of capital. profits; it is potentially the most productive type Thus, access to capital is strongly related to growth of capital, with a number of claims made for it; in the productivity of labor.” 4 and by most accounts, it is the hardest to obtain. Without the benefit of economic theory, non- Working capital can come in the form of either profit advocates and observers are advancing a equity (sometimes seen as grants in the nonprofit series of more specific claims about the need for context) or debt. and benefits of working capital, some made more Though this paper does not explore it at length, compelling by recent developments in the non- working capital has a second important meaning. profit environment. In contrast to the more strategic investments mentioned above, working capital can also serve as a Better organizations. Working capital could help ready supply of cash to cover the organization’s rou- nonprofits become more efficient and more effec- tine expenses during periods of low cash flow (e.g., tive. And as efficiency and effectiveness have before expected payments are made on grants or become ascendant concepts in the nonprofit sector, government contracts). Though no less vital and so has the idea of working capital as a resource to often more pressing than the strategic working cap- support them. ital, this type of cash-flow funding may be more Efficiency is increasingly framed as a matter of readily available to nonprofits. For example, non- technology, which quickly leads to questions of capi- profits can establish lines of credit with commercial tal: nonprofits feel they need better technology, and banks, or take “bridge loans” from loan funds spe- capital investments to purchase it. The work-force cializing in nonprofit organizations. development managers interviewed as part of a It is the idea of working capital as a source seven-city survey for the Rockefeller Foundation in of strategic organizational investment that seems 1998 consistently cited lack of information technol- especially salient today, in large part because of a ogy as a barrier to efficiency. They felt it hindered number of (sometimes-implicit) claims about the administration, case management and, ultimately, potential benefits of working capital. The discus- program evaluation and improvement (because it left sion below reviews these claims and their underly- them with weak databases that were hard to work ing assumptions. with). 5 The growth of information technology — and the fear that nonprofits are lagging behind for- The generic working capital claim: productivity. profits and government in their technological capac- In competent hands, working capital makes an ity — is surely driving a good a deal of the recent organization more productive. Susan Kenny attention to working capital. Stevens, a nonprofit financial consultant and man- A more comprehensive analysis, also growing in ager of over a dozen nonprofit loan funds, observes popularity, argues that investment in organizational Working Capital /10 Defining Nonprofit Capital and Its Benefits

processes will improve the overall effectiveness of a any one organization, have the option of investing nonprofit, helping it deliver better-quality services in replication or diffusion strategies instead of in and more efficacious programs. Systems for learn- organizational growth. ing, innovating and improving services, for exam- So organizational growth may be both an ple, can all contribute to effectiveness, and all irrefutable rationale for increasing the supply of require working capital to design and implement. working capital — and an irrelevant one. Like information technology, interest in organizational effectiveness may be at an unprecedented More competitive organizations. Working capital high point in the nonprofit sector. 6 can also be a competitive asset, particularly in We can explain why these arguments are markets where for-profits are active.8 The research salient, but are they compelling? There is, after all, literature does not seem to suggest that better- no guarantee that supplying nonprofits with work- capitalized organizations produce more value for ing capital will lead to more efficiency or effective- clients or communities. Comparative studies of ness, which may explain why foundations still tend day-care, home-health and other programs suggest to favor program-specific grants over general oper- that the outcomes of nonprofits and for-profits ating support. It may also explain why foundations (which often enjoy better access to capital) are quite that do make more working capital available may similar. 9 But even if program outcomes are the also want better oversight and input into nonprofit same, better-capitalized organizations may have a affairs, an important phenomenon discussed later. distinct competitive advantage over thinly capitalized ones. So where and when is lack of capital a signifi- Bigger organizations. Proponents of working capi- cant competitive disadvantage for nonprofits? Two tal almost always point out how important it is to types of markets would seem to pose special chal- organizational growth7, and their logic is unassail- lenges: scale-sensitive and risk-sharing markets. able. Growth means more staff, more facilities or equipment and more systems to manage all of these Scale-sensitive markets. In some cost-competi- — often in advance of any revenue from government tive markets, the only way for organizations to contracts or philanthropic donations. As in business, realize a profit or surplus is through growth, which where capital is generally raised to grow an organi- reduces their overhead as a share of total operating zation, so with nonprofits: no capital, no growth. expenses. As the founder of a for-profit after- But how many nonprofits really want to grow? school program said of the economics of her pro- And how many foundations are interested in sup- gram, “It doesn’t work for one school. It doesn’t porting that growth? At best, many nonprofits even work for five schools, and it just begins to might be considered ambivalent about growth. start making sense for 100 schools.” 10 Once larger Their devotion to a local mission and to personal organizations gain such efficiencies of scale, they one-on-one contact with their clients leaves many can begin offering yet more competitive prices. nonprofit employees indifferent to growth. CDCs The result, for smaller organizations, is competi- and work-force development organizations, for tive disadvantage. One way to cope is to grow, example, often see their mission in place-based which in turn would require expansion capital. terms. They may want to increase their volume through more contracts or development projects, Risk-sharing markets. Some competitive markets but they are not likely to want to pursue multi-site are shaped by risk-sharing contracts. For example, expansion. And foundations, often more interested under competitive performance-based contracts, in the general public good than in the fortunes of providers contracting with a government agency Defining Nonprofit Capital and Its Benefits Permanent Capital /11

forego some or even most of their fee if they cannot is the end-users, not nonprofit financial institu- deliver the result specified in the contract. Only tions that are accessing new supplies of working organizations with a capital base — and one they capital to expand their operations. The CDFIs — are willing to put at risk — can be competitive in though a critical conduit for this capital flow — these markets. Even if the provider delivers the end up facing many of the same cash-flow and result, it may still need a reserve to cover expenses strategic working capital challenges as any other until it passes the final milestone and triggers the nonprofit. full payment. It is important to note, however, that So these community development capital pools few nonprofits (or for-profits) are subject to pure are not like permanent capital in the strict sense: performance contracts. As an earlier scan suggested, they are not for the benefit of the organization work-force development organizations often found itself. But it would be wrong to treat them as ways — short of accessing new capital — to miti- working capital, since they do not function as such gate the effects of these contracts, which were for the nonprofit organizations that hold them. sometimes not as austere as advertised.11 ● ● ●

Even this fairly simple classification of different forms Permanent Capital of nonprofit capital and their purposes can help get us from thinking about a monolithic capital problem to a PERMANENT CAPITAL NORMALLY REFERS to more refined assessment of the various capital needs of endowments or reserves that are not meant to be a given nonprofit, or group of nonprofits. Facilities, liquidated until the organization goes out of busi- working and permanent capital satisfy different needs. ness, although they might be drawn upon occa- The strategies reviewed in the next section collectively sionally for special needs and opportunities, and address all these capital challenges, but individually the income they generate is often used as working they tend to focus on only one of them. Making these capital.12 For the purposes of this paper, permanent distinctions is critical to understanding how to respond capital will also be used to refer to the capital to any or all of the nonprofit capital challenges. pools of CDFIs, the organizations that provide credit and equity for community economic development projects (including housing, commercial real estate and business development). How to categorize these capital pools for community development is a thorny problem, and it points to a special challenge facing the nonprofit community development field. On the one hand, as will be clear by the end of this report, the challenge of capitalizing CDFIs has been met with impressive ingenuity and innovation: most of the technical solutions reviewed later are aimed at capitalizing these loan pools. On the other hand, capitalizing CDFIs does not, in the end, speak to the capital challenges of nonprofit organizations themselves. The end-users of CDFI funds are often businesses — not nonprofit organizations. And it

Strategies & Solutions /13 Strategies and Solutions for Nonprofit Capital Problems 3

HIS SECTION SUMMARIZES THE NONPROFIT CAPITAL SOLUTIONS that were cited most often in the literature and interviews. The solutions are Torganized into four strategies. This approach emphasizes how various innovators conceive of the nonprofit capital challenge, organizing them around four underlying theories of change: Reforming the Nonprofit Capital Market. Some analysts envision a more rational, segmented and therefore more efficient and responsive nonprofit capital market, emphasizing not so much the amount of capital available but the terms and consequences of that capital. Reforming Philanthropy. Many have focused on optimizing the impact of philanthropic dollars by making grants and gifts function more like working capital that nonprofits can use to improve their capacity and performance, and less like revenues that fund direct service provision. Reforming Nonprofits. Others argue that the nonprofits can generate their own working capital by operating more efficiently or by earning unrestricted income in the marketplace. Expanding Access to Private Capital. The big prize for a growing field of analysts, innovators and policymakers is direct access to the private capital market, which has led to a variety of innovations, most of which generate capital for community development projects (though not always the nonprofits that manage them).

A few innovations seemed to defy easy categorization, and one could argue about where to assign them, but it seems more useful to propose a comprehensive view of all the innovations, even with a few wrinkles, than to offer a mere catalogue. Market Reform /14 Strategies and Solutions for Nonprofit Capital Problems

Strategy #1 Improving Foundation Leverage

Reforming the Nonprofit This disorganized capital market affects founda- Capital Market tions as well as nonprofits. As Emerson suggests in a discussion about the respective roles of govern- SOME ANALYSTS AND ADVOCATES PROPOSE a bet- ment and philanthropy in funding nonprofits, ter organized nonprofit capital market as a lever the potential for leverage is greater in clearly seg- for improving nonprofit performance; enhancing mented markets. If foundations are working on the foundation leverage strategies; and expanding the assumption that their grants will leverage govern- supply of philanthropic capital available to non- ment spending, while at the same time government profits. They argue that the way that capital is funders are hoping to attract private philanthropic organized and deployed is nearly as important as capital, can either have an effective leverage strat- the absolute amount of money available. egy? Even within philanthropy itself, if all funders prefer to fund early stage work in the hopes of Reducing Transaction and attracting other donors, who will be left to take up Opportunity Costs the challenge? In response, the market-reforming This market-reforming analysis sees an indirect strategy calls for more segmentation, with funders but powerful link between the nonprofit capital making explicit their willingness to fund nonprofits market and nonprofit performance. The current at various stages of their development. nonprofit capital market is disorganized and not clearly segmented, which imposes high trans- Encouraging More Philanthropy action and opportunity costs on managers, who With Better Information for Donors are forced to spend huge amounts of time fund- Efficient markets are characterized by good infor- raising. And, argues Jed Emerson of the Harvard mation, which enables both customers and firms Business School, the funding they do get is to make informed choices. Building on this often packaged and conditioned — in small insight, the market-organizing proponents advo- amounts, with many restrictions, and without cate better information, particularly better infor- regard to the developmental stage of the non- mation for donors, which could raise their profit — in unhelpful ways.13 “The disorderliness confidence and therefore their willingness to and complexity of the philanthropic funding donate more money to nonprofits. environment,” according to Allen Grossman of At the conceptual level, several proponents of the Harvard Business School, “distracts nonprofit market organizing are working on the development management, shifting focus away from organiza- of standard metrics for assessing “Social Return on tional performance.” 14 Investment;” Jed Emerson’s work toward develop- As significant as these transaction and oppor- ing SROIs is both comprehensive and grounded. tunity costs are, Emerson emphasizes that a bet- His model, developed with colleagues at the ter organized capital market is not in itself any Roberts Enterprise Development Fund (REDF), guarantee of performance. It is a market that sup- tries to capture three distinct types of value created plies the appropriate forms of capital, “together by nonprofits: the “economic” value of their serv- with the presence of talented management and ices; the “social” value of the improvements to staff along with a little luck in the form of market clients’ lives; and the “socio-economic” value timing, which makes for success or failure in the enjoyed by society when nonprofits relieve it of nonprofit world.” 15 more expensive, remedial government services.16 Strategies and Solutions for Nonprofit Capital Problems Market Reform /15

REDF has run a two-year pilot effort to use Upwardly Global,a nonprofit work-force develop- SROIs to assess the value created by its grantees. ment organization for new immigrants, after a series The CDFI Data Project 17 is creating a CDFI of frustrating and time-consuming experiences try- data collection and management system that has ing to present her idea to established foundations. the potential to transform the way information is ● ● ● collected and used in the development finance field. Data on CDFIs is now collected by a variety The market-reform strategies envision an environ- of funders, trade associations and researchers, each ment more responsive to the needs of nonprofits at interested in different characteristics and segments various stages of their development. The capital strate- of the CDFI field. This comprehensive system gies that follow propose new roles and tools for the will minimize reporting requirements on CDFIs; various actors within that market. it will also improve the quality of CDFI data and enable practitioners to compare their organizations and programs to a broad group of peers. The project will make an important contribution through the standardized data set it produces. Eventually, this data will include standard outcome metrics for the field. Considering the difficulty of measuring social returns on investment and other outcome metrics, these indicators will emerge after the first year, after ample consulta- tion with CDFI practitioners. Others are working not on better metrics, but on more accessible information for donors, often by using the Internet. SEA Change,a new association advocating for the interests of social entrepreneurs, is considering launching a variant of Garage.com, which is a Web site where entrepreneurs can seek venture capital backing, and other resources, for their business ideas. In this variant, Garage.org, social entrepreneurs and philanthropists would seek each other out. In the San Francisco Bay Area, Craigslist Nonprofit Venture Forums provide an opportunity for start-up nonprofits to pitch their concepts and strategies to potential donors in a fast-moving process aimed at cutting down the pain of philanthropic matchmaking. The sponsor, Craigslist.org, sees the forums as an extension of their extremely popular Web site, which helps Bay Area residents connect with one other through postings about jobs, events, housing and volunteer opportunities. The venture forum was founded by Jane Leu, founder of Philanthropy Reform /16 Strategies and Solutions for Nonprofit Capital Problems

Strategy #2 them achieve their organizational improvement goals and to satisfy themselves that their funds are Reforming Philanthropy being well used. The most visible form of high-engagement IT’SPROBABLY NOT AN EXAGGERATION to say grantmaking is a style inspired by or modeled after that a new consensus is emerging that philan- venture capital. Since at least the 1970s, philanthropy could be the most important source of thropists have compared their role to that of ven- working capital for nonprofits — if foundation ture capitalists, pointing out that both focus on the practices were reformed so that restrictive grant development of new ideas for broader application. funds could function more like capital. By the early 1990s, a new set of practitioners and The initiatives reviewed below are all premised analysts began appropriating the metaphor to on this assumption, one shared by many of the emphasize a different point — that venture capital observers interviewed for this paper. The manager (and grantmaking styled after it) is important for of a stabilization fund complained that too many its ability to strengthen an organization’s capacity foundations are “promoting grant-seeking behav- to perform. This distinction between support for ior” that does not improve the ability of the organ- an innovation (in conventional grants) and support izations to perform or grow. A nonprofit finance for an organization is emphasized in the pioneer- consultant said the problem with most grants is ing work of the Roberts Economic Development that they are “controlling, not enabling.” These, of Fund and the Peninsula Community Foundation’s course, are the sentiments traditionally voiced by Center for Venture Philanthropy (both in the San nonprofit advocates seeking more general operat- Francisco Bay Area), and was explicated in a 1997 ing grants. analysis that ran in the Harvard Business Review.19 The emerging consensus, however, argues for Much of that analysis is now often obscured more than unrestricted funds: As much as non- by “venture philanthropy” — a catchall phrase profits need working capital, it is not always wise sometimes used to suggest strategic investment in for foundations to deliver it — unless they can do organizational capacity, but often used much more so in a way that ensures nonprofits will use it to generally to denote a results-oriented style or improve productivity and outcomes. Short of such ambience favored by many newly wealthy donors. measures, general operating support can become, Meanwhile, a number of less visible founda- in the words of Susan Kenny Stevens, “a budget- tions have been pursuing high-engagement philan- balancing wild card doled out by foundations as a thropy without reference to venture capital or philanthropic allowance.” 18 Instead of providing venture philanthropy. Preliminary analysis of the stimulus and resources for nonprofits to make research conducted on six such models by the strategic investments in their own capacity, she Hauser Center for Nonprofit Organizations argues, unrestricted funding can encourage a suggests that grantees benefit in two ways. First, “dependence mentality” in which desperate non- the grants from high-engagement funders tend to profits greet each new grant with enormous relief run longer than average, and are therefore a reli- — and then treat them as cash, not capital for able source of working capital for the nonprofits. organizational improvements. Second, the grantees benefit as much, or more, from general assistance with overall strategy as High-Engagement Grantmaking they do from any technical management assistance In high-engagement grantmaking, foundation staff the funders might offer or pay for. The net result work closely with their grantees, both to help is larger blocks of capital with a relationship that Strategies and Solutions for Nonprofit Capital Problems Philanthropy Reform /17

aims to ensure that it is used as a strategic invest- eventually wants a capital base of $25 million. ment in the nonprofit’s organizational capacity.20 Although the Local Initiatives Support Corporation (LISC) is a premier field-building Proprietary Intermediaries intermediary, advocating for and working with If we normally think of an intermediary as an CDCs across the country, it has helped launch a organization that raises money for and works to series of funding programs that provide CDCs build the capacity of a field of nonprofit organiza- with working capital and technical assistance, tions, we could think of a proprietary intermedi- more in the style of a proprietary intermediary. In ary as one that takes a narrower focus in funding a typical LISC Operating Support Collaborative, and improving a select handful of nonprofits a group of funders capitalizes a special fund and in a given field. The tactics of a proprietary hires staff to manage it. The fund targets a small intermediary would be very similar to those of number of CDCs in one city and provides rela- high-engagement funders and venture-capital tively large blocks of capital (as general operating philanthropists, although the intermediary is not support grants) over as much as five years. The incorporated as a foundation. grants support specific organization-building objectives that have been formulated by the par- New American Schools (NAS) provides an excel- ticipating CDCs and endorsed by the funders. lent example. Started in 1991 with grants from The funders, through their staff, then work closely foundations and corporations for the purpose of with the CDCs to monitor and improve their promoting education reform, NAS had awarded progress toward the designated goal. over $150 million in grants, mostly to help seven education reform organizations achieve large- Stabilization Funds scale implementation of their programs, before Pioneered by funders of the arts over 20 years ago, redesigning its strategy. NAS concluded that it stabilization funds provide nonprofits with endow- could never raise enough money in grants to fund ment or cash-reserve capital as part of a larger effort large-scale implementation. It decided instead to to improve their financial situations. The capital help the nonprofit school-reform organizations sell provided is generally not meant as working capital their services to school districts, which were bene- for immediate needs, but as a base that will generate fiting from increased federal and state funding for income over the long-term and, in some cases, be school reform. available as a reserve fund for special projects.21 NAS then began envisioning its role as that of The logic of the original funds for arts organi- an investor, providing working capital and other zations is straightforward: if these nonprofits had forms of assistance that would help the nonprofits the capital and knowledge needed for better mar- market their reform ideas to school districts. NAS keting, financial management and general admin- literally took a proprietary stake in the organiza- istration, they could improve their chances of tions by claiming ownership of their intellectual generating more revenue from ticket sales and property — the school reform program designs. become more stable. Although they might not be Although it continues to offer working capital expected to become totally self-sufficient, founda- grants, it now plans to offer debt that the nonprof- tion grants would not be what Stevens calls the its will repay when their larger-scale businesses “wild card” in balancing perennially mismanaged generate enough income. Prudential Insurance has budgets. Instead, they would provide resources for made a 10-year loan of $10 million to NAS, organizational improvement. bringing its capital base to $15.7 million; it The management assistance components of the Philanthropy Reform /18 Strategies and Solutions for Nonprofit Capital Problems

stabilization funds can be significant. National considering instituting the programs. The annual Arts Stabilization, the flagship of the funds, condi- value of the credits varies from $2 million to tions release of funding on achievement of desig- $15 million per state. nated milestones. It offers assistance with financial NAPs offer state tax credits to corporations planning, management and board development, all that agree to make commitments for large grants, aimed at strengthening the arts organization. It over a long period of time, to selected nonprofits. has recently embarked on what may be one of the Most require corporations to work with the non- few attempts to evaluate the outcomes of manage- profits on strategy development or organizational ment assistance to nonprofits. capacity building, sometimes mandating plans that The Ford Foundation, which has long been a outline the major objectives and milestones of the promoter of stabilization funds, made a series of nonprofits. In most cases, eligible nonprofits must large grants in June 2000 that are also aimed at be community-based organizations working to improving the capacity and financial stability of improve low-income areas, the goal being to move arts groups. Called “New Directions/New capital and expertise from downtown to struggling Donors,” the Ford initiative granted $40 million to neighborhoods. 28 organizations, with grants ranging in size from Pennsylvania was the first state to launch a $1.25 to $2.5 million. The grants carry a matching NAP and is considered to have the most ambitious requirement, and are intended to help arts organi- and innovative program. Enacted in 1967, and zations find a new donor base among the newly expanded in 1994, the Neighborhood Assistance/ wealthy. The Nonprofit Finance Fund will docu- Comprehensive Service Program offers $15 mil- ment the process and its outcomes. lion in credits. A participating corporation receives The Rockefeller Foundation has extended the a 70 percent state tax credit on donations made to stabilization concept beyond the arts in a 15-year a maximum of two nonprofit “partners.” The cor- program “to encourage independence and improve poration must agree to make grants of $250,000 the financial stability of four major civil rights liti- per year, per nonprofit for a 10-year period. The gation organizations.” Begun in 1985, the program grants are to advance the goals specified in a offered major grants that were to be used as quasi- Comprehensive Service Plan developed by the endowments (i.e., mostly for generating income nonprofits and submitted to the state. Participating over the long-term, but also available as cash nonprofits must be engaged in “comprehensive reserves for special needs or opportunities). This service programs” aimed at meeting both the physi- Basic Rights Stabilization Program was ambitious cal and social needs of the neighborhood.22 in its time commitments and grant sizes, granting the four nonprofits a total of $15 million in capital Program Related Investments in three five-year cycles, but was not designed to PRIs may be most notable in a discussion of non- provide management assistance. profit capital for their untapped potential. Authorized in the tax reform act of 1969, PRIs Philanthropic Tax Credits allow foundations to “invest” in nonprofits by mak- State tax credits for corporate philanthropy are ing below-market loans, provided that financial gain emerging as an appealing means for converting is not the primary motive of the foundation and philanthropic grants into significant sources of that the funds are not used for political lobbying. working capital for nonprofits. Commonly known Although the data on PRI use is thin, it does as “neighborhood assistance programs” (NAPs), support the widely voiced sentiment that PRIs are they are available in 16 states; four other states are not widely used. The Foundation Center’s most Strategies and Solutions for Nonprofit Capital Problems Philanthropy Reform /19

comprehensive analysis tracks the use of PRIs from 1993 to 1995. At that point, Ford and MacArthur accounted for approximately one third and 10 percent of total PRI activity, respectively. Nonprofits working in housing and community development attracted 63 percent of PRI dollars. Almost half of all PRIs were made to intermediaries.23 Although most were probably CDFIs, this review has noted the use of PRIs in intermediaries brokering tax- exempt bonds, a school-reform intermediary and long-standing intermediaries like LISC. Several observers concluded that PRIs are too demanding for foundations and nonprofits. Program officers (many carrying large grant portfolios) would have to invest considerable time in due diligence, deal structuring and negotiation to execute PRIs. And nonprofits, many averse to any kind of debt finance, may find the process too demanding as well. In opting out, according to some observers, they forego an excellent opportunity to assess nonprofits in a more “holistic way” and to address underlying capacity problems that might make it difficult to repay the PRI.24 The demands of PRIs may explain why so many are delivered through specialized intermediaries, which presumably have developed the technical competence to execute PRIs.

● ● ●

The philanthropic reform strategies hold real promise for meeting the capital needs of nonprofits. Though it’s true that foundation grants comprise a relatively small share of nonprofit income, foundations have the free- dom, motivation and, increasingly, the knowledge to make their grants function more like working capital. We turn next to the work nonprofits can do to meet their own capital challenges. Nonprofit Reform /20 Strategies and Solutions for Nonprofit Capital Problems

Strategy #3 not entirely vanished, to a much greater willingness to accumulate equity, use debt finance and approach Reforming Nonprofits financial management more as a strategy, and not just administrative competence. As Tim Freundlich WHILE MANY STRATEGIES ATTEMPT to change of the Calvert Foundation says, “There’s a growing the environment within which nonprofits work — maturation of capital structures in the nonprofit by organizing a more efficient market, reforming sector. People understand you can have debt.” philanthropy or making private capital markets accessible — others see nonprofits themselves as Become Bankable a major part of the solution to their own capital Some observers emphasized that with some more problem. Various analysts have proposed five ways technical competence and management assistance, nonprofits can ease their own capital challenges: most nonprofits can become bankable and access mainstream financial services. A long-familiar ➤ Become bankable — so they can access the huge analysis suggests that the gap between nonprofits banking finance system. (especially smaller ones) and banks is enormous. ➤ Generate working capital internally — by pricing But that view seems to be giving way in the face of services correctly and aiming to accumulate a new reality. surpluses. The traditional observation about banks is that ➤ Create/become self-sufficient nonprofits — by mak- they have not regarded nonprofits as profitable ing them “social enterprises” that are not depend- customers, and have therefore been largely indif- ent on subsidies but earn unrestricted revenue in ferent and inaccessible to them. Tuckman provides the market. a good roundup of explanations for this view in his ➤ Grow nonprofits — since many of the barriers to overview of nonprofit finance. Most banks, he rea- capital can actually be understood as the problems sons, do not understand nonprofit finances, and, of small-scale organizations. because of their ignorance, “see these entities as ➤ Convert nonprofits to for-profit status — since risky investments.” Even if they see a viable mar- investment equity is only available to for-profits. ket, banks might “fear adverse publicity that accompanies foreclosure on nonprofit property.” Proponents of most of these tactics emphasize that Those willing to foreclose on nonprofit property nonprofits will need to change their own culture, might end up with assets too specialized (e.g., a which often does not value capital, financial man- botanical garden or rural hospital) to resell.26 agement or organizational capacity. As Susan The longstanding view of nonprofits suggests Kenny Stevens points out, “Too many nonprofits that even willing bankers would not have found believe that producing even a modest year-end much of a nonprofit market. Nonprofits have long surplus is either against the rules or will render been viewed as simply not interested in, or edu- them unfundable.” 25 Another says the biggest bar- cated about, bank financing. They see themselves, rier for CDFIs — ironically, since they themselves according to one loan-fund manager, as “grant- are purveyors of capital to businesses — is their dependent nonprofits, not social enterprises.” “ideological opposition to business thinking” when Several observers challenged these conventional it comes to making their own operations more views. They see banks actively courting nonprofits, efficient and sustainable. and nonprofits increasingly aware of their banking These attitudes — as the review of practices options. Fleet Bank has invested heavily in non- below will affirm — are giving way, where they have profit business development — with advertising, a Strategies and Solutions for Nonprofit Capital Problems Nonprofit Reform /21

dedicated sales force and cultivation techniques a nonprofit board member), argued that “it doesn’t like sponsorship of conferences on topics make sense to get nonprofits worried about access of interest to prospective nonprofit customers. to capital when they haven’t taken care of the basics Citigroup has begun a systematic effort to market of running the operations well.” He sees a different its vast array of financial services to nonprofits, and progression, in which nonprofits work their way develop new products as well. Scores of other through a series of milestones, asking: banks, most on a smaller scale, are following suit. As a result, a few observers now emphasize a Do I have enough to get started? Do I have new challenge for nonprofits. Instead of needing enough to make payroll? How fast am I getting an education about the availability of banking paid from public agencies? Can I speed it up? services, they now need an education to help them How far can I push people in paying what I owe? select bank products that will be appropriate to Am I getting the most out of my board [in them. “Bank products,” cautioned one, “are donations]? Then, when the operation is running designed for bank profitability” — not for non- tightly and it’s time to think about growing it, profit needs. As an arts stabilization fund manager you’re ready to start looking for working capital put it: “When we needed banks, we weren’t bank- [from external sources]. able. When we didn’t need them, we were.” A CDFI advocate actually argued that too much Generate Working Capital Internally external working capital would distract CDFIs A number of observers argued that nonprofits from focusing on changing their pricing to gener- could and should generate their own working capi- ate self-sustaining revenues. To avoid the possi- tal by steadily accumulating surpluses to cope with bility that nonprofits would “hide behind capital” cash-flow problems and, more ambitiously, fund — e.g., use it to compensate for poor manage- the development of new programs or organiza- ment, not for improving management — he tional improvements. urged outsiders supplying capital to structure it As Tuckman argues, internally generated capi- around milestones, releasing it in a series of tal has some important advantages for nonprofits: installments when agreed-upon organizational funds are available when needed, the organization goals had been achieved. does not have to disclose information to outsiders The expectation that most nonprofits could and accountability is managed through normal generate equity by preserving surpluses may seem board oversight 27 (as opposed, for example, to misplaced. Yet research suggests that the vast some of the intensive relationships with high- majority of nonprofits, including smaller ones, are engagement funders). in fact able to generate their own working capital. Several observers who emphasized the need for Some do so by taking income from endowments, internally generated capital stressed that it is not but “funds accumulated out of cash flow are almost only desirable but essential. If a nonprofit is unable certainly a major source of capital funds.” 28 to generate internal working capital, then capital Tuckman and Cyril F. Chang (see Related provided by foundations will be very risky. Capital Readings) studied the IRS filings of over 4,500 in the hands of an organization that cannot man- charitable nonprofits for 1983 and found that age to generate a surplus may not be an invest- more than 86 percent of them reported a surplus ment in improved capacity or productivity at all, of revenues over expenditures. A 1986 study of a but rather a bailout for incompetence. larger sample confirmed the finding. And when A banker specializing in nonprofit markets (also the researchers weighted the data to account for Nonprofit Reform /22 Strategies and Solutions for Nonprofit Capital Problems

the fact that the smallest nonprofits (with under Roots of the self-sufficiency paradigm: $25,000 in revenues) were not represented Funding scarcity. Not surprisingly, the idea of a (because they aren’t required to file tax state- nonprofit that earns its revenue in the marketplace ments), they found 75 percent of nonprofits were is almost always linked to funding questions — of generating surpluses they could use as equity.29 where nonprofits will get revenue and how they How do these findings square with the general will access capital. Observers and proponents cite assertion that nonprofits lack capital? One possibil- a scarcity of public and philanthropic funds as the ity is that nonprofits, many of whom exhibit a underlying rationale for converting nonprofits scarcity mentality, may be developing scarcity from heavily subsidized charitable institutions into budgets that are easy to meet. They are budgeting self-sufficient social enterprises.32 not against what they aspire to accomplish, but Although they do not link their analysis to against what they think is available. Having set the social enterprise, Alan J. Abramson, Lester M. bar low, they then pass it. Nonetheless, the findings Salamon and C. Eugene Steuerle do make the do suggest that the habit of aiming for surpluses most elaborate case supporting the popular view has already been cultivated, and that what remains that nonprofits face debilitating scarcity. Reviewing is to expand the scale of this practice. two decades of federal spending, they conclude In the interviews, several observers argued that “budget shifts generally increased the pres- that cost accounting was the major challenge for sures on nonprofit organizations to expand their nonprofits seeking to generate significant supplies services, while reducing the resources they had of working capital internally. According to Gary available to do so, at least outside the health Mulhair of Community Wealth Ventures, non- field.” 33 Federal spending on community develop- profits should be “externalizing their costs” by ment, for example, was one percent lower in 1997 charging government funders the true cost of than it was in the study’s benchmark year of 1980. services and “internalizing their cash” by saving While spending on social services was up 22 per- surpluses. The same applies for nonprofits that cent over 1980 levels, the analysts argue that if charge fees, such as CDCs with development federal outlays had remained steady in the inter- fees, and CDFIs with loan fees. “The savvier and vening years, an additional $35.1 billion would less ideologically constrained” CDFIs, for exam- have been spent between 1980 and 1997.34 ple, “recognize you can charge loan fees and they But the picture is more complicated — and don’t break deals.” But to charge the true cost of almost certainly not as dire as the analysts sug- services or appropriate fees requires some compe- gest. As Steven Rathgeb Smith argues, state and tence in cost accounting, still a challenge for local governments have often stepped in to com- many nonprofits. pensate for the loss of federal funds. More nonprofits, moreover, have been able to fund a wider Become Self-Sufficient, or Create range of services out of Medicaid — one of the Social Enterprises few areas enjoying real growth in spending. Far more ambitious than a strategy of generating Finally, the federal cutback analysis failed to (or surpluses as working capital is the emergence of a could not on account of timing) recognize some new paradigm, in which nonprofits are considered important sources of funding — including both capable of becoming virtually self-sufficient by long-standing tax expenditures like the Low selling services or products in the marketplace.30 Income Housing Tax Credit and new funding for Although hardly a new concept,31 it is more preva- welfare-to-work services. Federal spending may lent and influential than ever. be preferable to state or local spending, and direct Strategies and Solutions for Nonprofit Capital Problems Nonprofit Reform /23

funding may be more efficient than tax credits, daughters, business-school students, unemployed but it doesn’t follow that nonprofits lose revenue people and, of course, nonprofits. as a result of these policies.35 Several initiatives promote social enterprise by Social enterprise proponents also point to the nonprofits more specifically. Community Wealth ever-increasing competition for philanthropic dol- Ventures, a subsidiary of Share Our Strength, is lars.36 Yet philanthropy is growing briskly, at this a for-profit that helps nonprofits develop “earned point probably faster than nonprofit expenditures. income activities.” The National Center for According to The Foundation Center, “Overall, Social Entrepreneurs offers both consulting and foundation giving has grown more than two and training. The Denali Initiative promotes social one-half times since 1990.” Foundations made enterprise as a means of improving neighborhood grants worth $22.8 billion in 1999, up from quality of life. Most recently, SEA Change $19.46 billion in 1998. Even the pessimistic analy- emerged as an association for social entrepreneurs sis of Federal funding concludes that “the real and their proponents. While it may be doubtful growth in private giving…was 3.7 times the rev- that nonprofits need to attain self-sufficiency, it’s enue losses experienced by nonprofits.” 37 clear that many want to. Although the idea that nonprofits must become self-sufficient because government and Social enterprise and capital. Social enterprises philanthropic funds are shrinking may be flawed, aimed at self-sufficiency solve one type of capital this does not necessarily make the argument for problem, but generate another. A nonprofit that social enterprise less attractive. A more compelling succeeds in offering a service in the market can rationale may be based on self-sufficiency as a gain the enormous benefit of unrestricted income, value in its own right. the surplus of which becomes working capital. But in order to develop the capacity and scale to reach Roots of the self-sufficiency paradigm: that point of self-sufficiency, social enterprises, like Affirmation of Values. For many proponents, any enterprise, normally require upfront or work- social enterprise is not merely a strategy for ing capital. responding to scarcity, but more fundamentally an An assessment of social-purpose businesses affirmation of values. According to J. Gregory funded in six cities as part of the Venture Fund Dees, a leading academic observer of social enter- Initiative suggests that social-purpose businesses prise, many nonprofit leaders “now consider exten- often face the same kind of capital crunches as tra- sive dependency on donors as a sign of weakness ditional nonprofits. The Initiative was launched to and vulnerability.” 38 assess the financing and technical-assistance needs Indeed, nonprofits are operating in a society of nonprofit-sponsored businesses. (Many of these that has never valued or promoted entrepreneurism were formed on the sheltered-work model, which more, or more widely, than ours does today. creates a business for the purpose of employing Several think tanks and nonprofit consulting firms and training people who need intensive support are dedicated to promoting entrepreneurism in before they are ready to compete in the open labor general, or social enterprise more particularly. The market.) The study found the capital problem was Kauffman Center for Entrepreneurial Leadership especially acute when a social-purpose business: funds and documents dozens of entrepreneurism efforts — aimed at Boy Scouts, community- begins to grow and needs to expand its facilities, college students, 8- to 12-year-olds, elementary equipment, staff, inventory or some combination school students of all ages, teams of mothers and of these, in order to keep up with demand. By Nonprofit Reform /24 Strategies and Solutions for Nonprofit Capital Problems

this point, many nonprofit organizations are effec- Though it may represent a healthy affirmation tively “tapped out” — they have already invested of innovation, risk-taking and determination, whatever discretionary funds might have been social enterprise can hardly be a panacea to the available when they created the business. And capital challenges of nonprofits. Self-sufficiency is whereas potential sales growth might easily justify not always feasible nor, given the potential con- a loan, there is little or nothing left to collateralize flicts with mission, is it always desirable. that loan.39 Grow Nonprofits This capital gap notwithstanding, social-purpose Since it is small nonprofits that tend to face the businesses that manage to develop a large biggest barriers to capital, some observers reason enough revenue base still might be able to gener- that we should encourage the development of ate their own working capital, and thereby fewer, larger nonprofits. Bigger nonprofits, in become less dependent on government and phil- short, get more capital. If we exclude religious anthropic funders. nonprofits and private foundations, about five per- Even more ambitious than these social-purpose cent of organizations that have enough revenue to businesses, which accept the need for some subsidy, require them to file statements with the IRS con- is the idea of totally self-sufficient social enter- trol 80 percent of the assets among those organiza- prises, designed explicitly to generate revenue to tions.43 Closer to community development, a support the nonprofit’s mission. Several observers recent study of CDFIs, for example, showed five are cautious about the prospects for these. Dees percent of the sample organizations controlled 49 points to research findings that over 70 percent of percent of the capital. 44 all business start-ups fail within eight years, sug- Clara Miller of the Nonprofit Finance Fund gesting that a social-enterprise path is hardly a describes access to capital as a function of both the guarantee of success, or even any easier than tradi- organization’s size and the complexity of its finan- tional fund-raising.40 Jim Thalhuber of the Nation cial needs. Big and small nonprofits alike, if they Center for Social Entrepreneurs makes a similar need only simple loans, can work with banks. Big point, suggesting that many nonprofit managers nonprofits seeking more complex forms of finance ought to start thinking like entrepreneurs, seizing — such as tax-exempt bonds — can still find the opportunities available within the world of sub- underwriters or investment banks willing to service sidies, before starting real businesses. 41 One them. It is the small nonprofits that want access to observer argued in an interview: “Most nonprofits more complex forms of capital that face the most aren’t ready for this. They don’t have enough staff, daunting challenges. risk tolerance or enough commitment to growth.” Though Miller doesn’t argue that small non- Others question whether self-sufficiency may profits should grow their way into a more friendly even be a harmful goal. Joshua Wallack, in an market, others do. Several argued that CDCs, in analysis of 14 social-purpose businesses, argues particular, suffered from their small scale: they that profitability should be a secondary goal in have trouble generating development fees because many social enterprises.42 It may be better, for of their small markets; they lack the capital to example, to offer extensive sheltered-work oppor- develop big projects; and they suffer from ineffi- tunities to some clients, even if it requires a sub- ciencies because they end up managing a relatively sidy. Seeking profits first might create a work small asset base. “Why have 2,000 small CDCs environment unsuitable for the very clients meant each managing 250 housing units unprofitably,” to benefit from the program. asks one, “when you should really have lots fewer, Strategies and Solutions for Nonprofit Capital Problems Nonprofit Reform /25

each managing thousands of units profitably?” not make sense. It may simply convert from a Some responded by arguing that small nonprofits struggling nonprofit to a struggling for-profit. often fill important but narrow niches by offering Meanwhile, the new for-profit would no longer specialized services or dealing with specialized be eligible for philanthropic funding. client populations. ● ● ● It is possible to improve access to capital without necessarily growing an organization. Secondary Reforming philanthropy to increase working capital markets, says Frank Altman, can help “hundreds and then reforming nonprofits to encourage self- of organizations with little pots of money” get sufficiency would go a long way toward addressing the more capital into their communities, often target- working capital problems of nonprofits. But they pale ing capital where it is most needed because their next to the prospect of easy access to the private capital small size gets them closer to the grass roots. And market, the final strategy in our review. strategic alliances of many kinds — joint ventures, subcontracts or variations on health care’s preferred provider networks — can allow nonprofits to attain the benefits of scale without having to grow. Convert to For-Profit Status Another option, rarely noted because it’s rarely feasible, is for a capital-starved nonprofit to convert to for-profit status as a means of accessing the private capital markets. The logic is straightforward: since nonprofits are prohibited from distributing profits, and therefore cannot attract investors, convert them to social-purpose businesses that benefit both a mission and their investors. That is a plausible strategy only in certain cir- cumstances. First, the nonprofit seeking to convert must be in a profitable market that will reward investors with steady and growing revenues. While conversions of nonprofit hospitals to for-profit status increased steadily over a 20-year period, they were driven entirely by the prospects for profitability. When profitability declined, in part because of caps on spending by Medicaid and Medicare, “deconversion” — from for-profit to nonprofit — actually outpaced conversions.45 Second, much of the logic of investment turns on scale: greater profits come with growth, and, by the same token, larger size enables organizations to raise money by issuing publicly traded shares of stock. For a nonprofit to convert to for-profit status without the benefits of operating and investment scale may Institutions /26 Strategies and Solutions for Nonprofit Capital Problems

Strategy #4 These tactics (which in some cases are com- bined) help nonprofits access different forms of Expanding Access to Private capital. While some of them generate sought-after Capital Markets working capital, most actually generate or expand permanent capital pools that nonprofits are PERHAPS THE MOST ATTRACTIVE STRATEGIES for charged with lending and investing as part of their better capitalizing the work of nonprofits are those community development activities. The result, in that aim to improve the access of nonprofits to the some cases, is that nonprofits can gain a toehold in private capital markets, where hundreds of thou- the huge private capital markets but may still lack sands of individual and institutional investors are working capital for their own operations. seeking investment opportunities to suit many tastes. The private capital market — with its vast Institutional Strategies sums — has enormous appeal to nonprofits accus- Particularly over the past 15 years, a growing num- tomed to small and unreliable flows of philan- ber of lending and investment institutions have thropic and public funds. The challenge is to find been designed to help low-income communities spots where the missions of nonprofits and the access philanthropic, public and private capital to objectives of investors intersect. support their mission of community development. Although they all rely on access to these huge The larger universe of these institutions — and capital markets as their lever, the strategies one notable subsector — are described below. reviewed below stress different means toward that end, with four tactics predominating: Community Development Financial Institutions. The term Community Development Financial ➤ Institutional strategies. When willing investors and Institution (CDFI) emerged in the early 1990s appropriate finance tools are available, new insti- as advocates from a number of specialized commu- tutions — able to work with distressed communi- nity development finance organizations began ties and investors — are sometimes seen as the to advance a more coherent and comprehensive critical resource. agenda. Both the name and the field became ➤ Technical innovation. Many finance techniques more prominent with the passage of the Riegle that are standard in business remain exotic to non- Community Development and Financial Institu- profits. Several efforts aim to adapt the most tions Act of 1994. This law directed the Treasury promising of these financing tools for use by non- Department to establish the CDFI Fund, which profits, thereby helping them reach private provides relatively small capital infusions to CDFIs investors. that meet its criteria for advancing community ➤ Government policy. Even with appropriate tools development. Over $300 million has been awarded and institutions, many investors find community to date. development or other nonprofit opportunities too Though the term describes the mission they risky, which has prompted public policymakers to offer various incentives and regulations to induce share, CDFIs themselves take many forms, includ- more investment. ing community development loan funds, credit unions, community development banks, venture ➤ Investor behavior. Even when government induce- capital funds, microenterprise loan funds or even ments are not available, it still may be possible to cultivate a new breed of social investors who will- commercial banks or their subsidiaries. They offer ingly invest part of their portfolio in community both debt and equity, including mortgages for development or other nonprofit opportunities. affordable housing, community facilities financing, Strategies and Solutions for Nonprofit Capital Problems Institutions /27

commercial loans and investments for business over 50 funds, with over $300 million under man- development, and finance for housing rehabilita- agement. The average median capitalization per tion, construction or acquisition. fund was $9.6 million.47 CDVCFs typically make National Community Capital, as an association investments of $100,000 to $1 million in compa- for the field, conducted a detailed study of 51 of nies with as few as 10 to as many as 100 employ- an estimated 475 CDFIs to identify critical char- ees. Although some fund sponsors are incorporated acteristics and challenges.46 They found: as for-profits, most were started by nonprofit community development organizations that discovered ➤ CDFIs were better capitalized in 1998 than 1997, that “debt simply was not an option” for many of with the sample’s aggregate base up 56 percent for the businesses they wanted to grow. 48 a total of $742 million. Mainstream venture capital is a high-risk ➤ Only about 25 percent of the sample’s capital was investment strategy, and community development liquid, indicating that most of the capital is at venture capital is even riskier on several counts, work in investments and debt aimed at community most related to its small scale. The funds are gen- development. erally working not only in depressed areas but in ➤ Though they are making progress, most CDFIs small markets within them — often a specific are not self-sufficient. Forty-nine percent of the neighborhood. This reduces the chances of their sample was able to cover 70 percent or more of its finding viable (much less extremely profitable) operating costs through earned income, up from business propositions. While mainstream venture 39 percent the previous year. capitalists vet on average between 450 to 500 pro- ➤ The cumulative loss rate was 1.7 percent. posals to find a small handful worth backing, ➤ Consistent with the distribution of assets in the CD venture capitalists have much smaller pools nonprofit sector at large, the five largest CDFIs to choose from. 49 in the sample held 49 percent of the sample’s In addition to serving small areas, the funds total assets. themselves have small asset bases. Their average ➤ The smallest 10 CDFIs accounted for only 1.2 per- capital base of $5.8 million (compared to the aver- cent of the sample’s total aggregate capital base. age $80 million mainstream venture capital fund), does not usually generate enough income to pay As these findings suggest, CDFIs represent a for the fund management. A fund of that size, maturing institutional strategy, and form the base with a standard 2.5 percent management fee and on which other efforts to attract private capital two full-time staff, generally requires a subsidy of can build. $75,000 per year to sustain itself. 50 Most observers consider $10 million to be the minimum for creat- Community Development Venture Capital ing a self-sustaining fund. 51 Funds (CDVCFs). CDVCFs represent only a But as Kerwin Tesdell of the CDVCA points small share of CDFIs and an even smaller share out, many of the newer funds may well prove to be of the entire nonprofit capital system, but they self-sustaining over a longer period of time; if sev- are important because they attempt to provide eral profitable deals pay off, they could well cover equity capital — as opposed to debt — to new expenses incurred over a number of years. or growing businesses, often in economically With small portfolios and target markets, depressed communities. CDVCFs have fewer opportunities for big profits. According to the Community Development The companies they back are often not likely to Venture Capital Alliance (CDVCA), there are reach the stage where they can issue stock, which Technical /28 Strategies and Solutions for Nonprofit Capital Problems

means there are few opportunities for the initial can deliver general management and strategy assis- CDVCF to sell its stake and take a profit that tance to the investees, it focuses its value-added could be reinvested in other deals. And the small, assistance on human resource issues. Specifically, less profitable investments of CDVCFs cost as it helps employers recruit, retain and develop much as larger deals because the “level of assistance entry-level employees by drawing on the resources required for often lower-skilled entrepreneurs in of the work-force development subsidiary of the distressed areas can be substantially greater.” 52 parent nonprofit. A recent analysis by policy student Luiz Lopez The prospects for CDVCFs may improve fur- explores a troubling consequence of these difficul- ther as the field matures and works on educating ties: CDVCFs have difficulty attracting investment investors and policymakers. The Community capital. Current investors are primarily motivated Development Venture Capital Alliance, in addition by social concerns, not financial return, keeping to advocacy and learning, has established its own CDVCFs at the margins of the mainstream mar- central fund to help capitalize CDVCFs. With ket. Given all these difficulties, it is not surprising $3.4 million from the CDFI Fund and $2 million that a 1992 study by the Community Development in PRIs from the Ford Foundation, it is aiming for Research Center found that more than 40 percent $10 million. of CDVCFs that started venture capital funds later abandoned them.53 Technical Innovation None of this means, of course, that the mission The last five years have seen several important of CDVCFs is not compelling or worth the trou- technical innovations aimed at helping nonprofits ble. Nor is every CDVCF a small-scale struggling access the private capital markets. enterprise. DVCRF Ventures — for Delaware Two of them — the Capital Markets Access Valley Community Reinvestment Fund — is one Program and the Community Economic Develop- of a few especially promising leaders in the field. ment Program of New Hampshire College — One of a number of work-force and community are developing a comprehensive approach to this development programs operated by the parent strategy. The Capital Markets Access Program, Reinvestment Fund, DVCRF Ventures has a program at the New School University run by amassed a $10 million capital base after only two Greg Stanton, is a combination think tank and and a half years. According to Fund president laboratory. It convenes practitioners from commu- Jeremy Nowak, about half the 26 limited partners nity development finance and the investment are high net-worth individuals, and the other half community to develop new mechanisms for are institutions — including foundations, banks enhancing capital access, while it also functions as and other venture capital firms. a technical-assistance resource, helping nonprofits The Fund’s objective is the creation of good access lower-cost debt, improve cash flow through entry-level jobs in greater Philadelphia. The eight bridge financing and issue tax-exempt bonds. companies in their first-round portfolio have cre- New Hampshire College is just organizing a ated 750 jobs in less than three years — a figure Financial Innovations Roundtable, where commu- expected to surpass 1,000 by 2001. All the jobs pay nity development finance specialists will work a minimum hourly wage of $9 and offer medical with investment and finance experts to explore benefits. The companies are in high-end manufac- similar strategies. turing and fast-growth service areas, including call Already, the Capital Markets Access Program centers and child-care centers. has sharpened what some observers see as a fun- Though the Fund’s staff and partners’ network damental challenge in accessing private capital Strategies and Solutions for Nonprofit Capital Problems Technical /29

markets. As one observer from community devel- ment projects. Generally, these lenders (who are opment finance described it, strategies like these “loan originators” in the secondary market food assume “we’re trying to build a bridge across the chain) support multi-family mortgages and eco- Charles River when it’s really the Pacific Ocean.” nomic development projects.54 They have assem- He observes that Wall Street finance experts come bled their original capital pools with difficulty, to the conversation with the “assumption that combining public, philanthropic and social-invest- ‘once you see how much money we have — you’ll ment dollars to reach a critical mass. “To survive,” do whatever it takes to get access’.” The com- according to financial analysts Kathleen Kenny munity development finance practitioners, mean- and Frank Altman, “community development while, come to the conversation saying, “We need lenders must look to an emerging secondary mar- [what investors would consider] illiquid, low-cost, ket to replenish their capital.” 55 high-risk capital.” The capital markets, in other The Community Reinvestment Fund (CRF), words, would have no interest in community formed in 1988 in Minnesota, pioneered creating development. a secondary market for community development As another observer worried, if nonprofits push loans. Capitalized by foundations and corpora- too hard to make themselves appealing to main- tions, CRF has purchased more than 700 economic stream markets, they will abandon the kinds of development and housing loans from 73 loan funds difficult, riskier and unusual deals that they were in 18 states, returning more than $114 million created to develop in the first place. into the community development lending system. Several promising innovations, however, sug- Though it holds much of the debt it acquires gest that there are some opportunities for progress (sometimes leaving the servicing of the loan with short of such a difficult trade-off. the original lender), it has issued 10 series of Community Reinvestment Bonds totaling $34 mil- Secondary Markets. Effective secondary mar- lion to 30 investors. kets have enormous appeal for lenders. In a Kenny and Altman point out that the emerging secondary market, a lender can sell all of the out- market faces several challenges. Chief among them standing debt it has issued to individual con- is a lack of shared practices among the community sumers, and then use the capital raised by the sale development lenders. Consistent loan documenta- to make a new generation of loans. The purchaser tion, common approaches to underwriting and of the debt can hold the mortgages, or as is often uniform risk-weighting practices are the key to done, convert them into bonds and sell them to successful markets because they improve the infor- other investors. This is the practice that Fannie mation available, make transactions more efficient Mae and Freddie Mac have perfected for single- and, in the process, reduce the cost and risk of the family home mortgages, and its success in replen- transactions. Unfortunately, the local, usually ishing the capital pool of lenders is credited small, loan funds do not enjoy any of these stan- with the high rate of homeownership in the dardization benefits. The “financial infrastructure” United States. — like a “ ‘string’ of relationships along the financ- Community developers have been working for ing pipeline from loan originators to investors” — over 10 years to extend secondary markets from is also weaker and less predictable than its private single-family homeownership to multi-family and counterparts. Finally, pricing is a problem, in that other economic development projects. Public and originators often lack the experience and knowl- nonprofit loan funds hold an estimated $4 billion edge needed to value their assets for sale in a in loan assets that support community develop- mainstream marketplace. Technical /30 Strategies and Solutions for Nonprofit Capital Problems

Because of these obstacles, and the nature of to purchasing community development loans, will the underlying loans, the secondary market “may also acquire selected affordable-housing properties always require some form of credit enhancement through a swap with owners who, for tax planning to attract large numbers of investors.” Foundations reasons, would rather own units in a REIT than or socially responsible investors, for example, can individual properties. CDT will commit to long- take higher-risk stakes in intermediaries like CRF. term ownership of the affordable housing. The flagship in the secondary market, the Local Initiatives Managed Assets Corporation Tax-Exempt Bonds. Larger nonprofits long had (LIMAC),illustrates a second-generation innova- the option of issuing tax-exempt bonds if they tion aimed at improving the secondary market could secure the sponsorship of a willing govern- for community development lenders. Created by ment agency (often a state facilities authority). The the Local Initiatives Support Corporation (LISC), transaction costs for evaluating, underwriting and LIMAC’s goal was to purchase mortgages on servicing bonds, however, have typically been too properties (e.g., small, scatter-site or assisted- high for smaller nonprofit organizations. An inno- living) not normally served by the mainstream sec- vation developed to service the needs of smaller ondary market. Capitalized with grants and PRIs community health providers could offer a model from foundations, it had steadily increased its pur- for other smaller nonprofits. chases of loans, until its own capital base dwindled The Community Health Facilities Fund to $4.5 million, raising the question of how to (CHFF) was incorporated as a nonprofit by three expand the secondary market if upstream funds national associations representing local community were drying up. health organizations. Capitalized with PRIs from Like many other nonprofits, LIMAC wanted the Robert Wood Johnson Foundation, the Fund what nonprofits cannot get: equity from investors. is managed under contract by the firm of Capital It resorted to conversion to for-profit status, just as Express Limited, LLC. The Fund is a vital link insurers and hospitals facing capital crunches have between the nonprofits and the investment com- over the past 20 years. By converting itself to a munity, and can package and explain nonprofits’ real-estate investment trust (REIT), though, needs in ways the market can accept. This inter- LIMAC got the best of both worlds. It could mediary function is critical. As Tuckman points access capital from investors but take advantage of out in a review of various nonprofit finance tools, the fact that REITs do not pay corporate income “Bond houses are not likely to issue bonds in many tax. (A REIT combines the capital of many of the areas in which nonprofits might wish to investors to acquire real estate or provide financing borrow because of the effort involved in develop- for it; it functions like a mutual fund for investors, ing loan criteria and in learning the intricacies of offering them diversification but no property man- a new industry.” 56 agement responsibility.) The Fund’s biggest job with investors is to The REIT operator, the for-profit Community explain the nature of the nonprofits’ government Development Trust (CDT), launched in 1998, funding. Although backed by real estate, under- quickly assembled a capital base of more than writers need evidence of reliable income, and $30 million. LISC contributed $1.5 million, and those unfamiliar with nonprofits are apt to see all a group of 18 investors (including Prudential government funding as unreliable. Nonprofits Insurance, Fannie Mae and Met Life) invested as offering government-funded services that might well. LISC has seven of 15 board seats, with other be considered essential are the most attractive to investors holding the balance. The Trust, in addition investors. A provider of residential care to the Strategies and Solutions for Nonprofit Capital Problems Technical /31

severely disabled, for example, is unlikely to have Express points out, “We see ourselves as enterprise its government funding disrupted, since these developers using real estate as collateral.” If the clients are entirely dependent on the service and facilities in question support a viable business the government has no easy alternative. In con- plan, long-term, low-cost debt can support and trast, a provider of job training and placement strengthen the organization’s capacity for growth. services — which are not considered essential — As with all suppliers of capital to nonprofits, is much more at the whim of changing public the challenge is ultimately one of creating the ini- policies and would be a much higher risk. tial capital pool. Beyond the initial PRIs from The Fund also works intensively to educate the Robert Wood Johnson Foundation, the Fund nonprofits about the advantages of debt in general, seeks social-investment capital (at concessionary and lower cost tax-exempt debt in particular. rates) or recoverable grants to: (a) subsidize its According to the Fund’s research, debt as a share operating costs as intermediary; (b) provide credit of total assets is 50 percent for the largest nonprof- enhancement (commitments to make payments to its (with budgets of over $50 million), and a quar- investors in case of default); or (c) provide “ware- ter of that debt is in the form of tax-exempt housing” — funds that enable the intermediary to bonds. For smaller nonprofits (with budgets of issue debt to borrowers before bonds have been $1 million to $10 million), debt is generally only sold on the market. 20 percent as a share of total assets and, of that, only five percent is in the form of tax-exempt Securitization of Accounts Receivable. A few bonds. Consequently, the Fund serves only a small observers proposed, and then several more were slice of a huge market — the small to medium- asked to react to, the idea of extending a bond sized nonprofits with assets and income between approach from facilities to working capital. They $500,000 and $20 million, seeking average loans propose that a nonprofit could raise important of $1.5 million. It figures that total annual demand sums of working capital by issuing bonds that of nonprofits in this target market might be close would be secured not by real estate but by accounts to $1.5 billion. receivable, presumably from government contracts. The Fund’s first approach was to bundle the There are several challenges to this securitization borrowing needs of smaller nonprofits into pools approach (so-called because it converts an asset into that would justify the transaction costs of issuing a security that can be sold on the market). For the bonds. This process forced each participating one, the risk of unsecured lending, particularly to nonprofit to wait until all others in the pool were smaller nonprofits, would be prohibitively high, ready to participate in the bond issue, creating and the idea almost by definition would require the long delays for many of the nonprofits. Under a involvement of a philanthropic-backed intermediary new securitization model, the Fund is able to pro- to provide credit enhancement and guarantees. vide debt finance to nonprofits on a rolling basis, Additionally, as one observer pointed out, as soon as they have met all the requirements. The securitization works in commercial markets by Fund then converts the debt into investment-grade exploiting huge volumes of debt with the same bonds for sale in the market. characteristics. The credit-card debt held by Since bonds are issued for new construction, banks, for instance, can be converted into bonds purchase or rehabilitation of facilities (or for refi- and sold on the market because everyone under- nancing of them), and are secured by real estate, stands the historic default rates, and therefore, can they are, strictly speaking, another form of facili- assess the risk. Most of what nonprofits would ties capital. But as Chris Conley of Capital want to securitize is “non-conforming, small-scale Technical /32 Strategies and Solutions for Nonprofit Capital Problems

debt,” which would require an intermediary to capital locked up in equipment and facilities, but bundle it into larger-scale offerings, just as CHFF need cash to expand or improve their operations.57 does with facilities-backed bonds for the mental In a typical deal, the property owner sells its health nonprofits. asset to a buyer who, for diversification and tax The intermediary would doubtless have to take purposes, wants to hold a depreciating asset. The on the challenge of educating potential investors new owner then enters into a long-term, renew- about the nature of government funding streams able lease, returning both control and asset-man- (which would provide the income needed to repay agement responsibility to the previous owner, who the debt). Many investors, according to the now has a new supply of working capital as well. observers who have considered this idea, consider Peter Nessen of Corporate Realty Investment government funding almost entirely unreliable, Corporation (CRIC) in Boston has begun struc- which dooms the prospects for accounts receivable turing net-lease finance deals for nonprofits. As an securitization. As one banker who has explored, intermediary, CRIC buys the properties of non- and likes the idea, rejoined: profits that need working capital, and then leases the property back to the nonprofit. CRIC then Let’s not overcomplicate it. We consider U.S. converts the leases it holds into investment-grade Treasuries [e.g., government-backed bonds] to be bonds and sells these at market, generating income the ultimate conservative investment, and need to for its investors. It also resells the newly acquired get people to see that government contracts are property and collects a transaction fee from the ultimately backed by the same government. They property seller. will pay. It’s true that they can change the rules of The arrangement, according to Nessen, can be the game, but they’re not going to do that willy extremely beneficial for nonprofits. He offers the nilly. Practical and political considerations will case of Northwestern Human Services, a multi- keep them in line. state operator of residential and community-based human service programs. Northwestern sold In addition to providing credit enhancement, 39 properties — offices, residences, community an intermediary would need to assess the reliability facilities and a new juvenile detention center — for of various funding streams, looking for what the $27 million, providing important capital at a time operators of CHFF call “essentiality” — evidence of intense competition. (Another nonprofit in the that the government funded service is so impor- same field, Abraxas, faced similar demands for capi- tant that payments are unlikely to be halted. tal and ultimately decided to allow a publicly traded This idea also assumes a financially and manage- for-profit prison management firm to acquire it.58 ) rially sophisticated nonprofit that is able to under- As with other sophisticated tools, this requires stand the role of debt in its capital structure, has a nonprofit with the ability to assess the benefits enough confidence in its plans and abilities to justify and risks of such a transaction. It must be confi- amassing working capital, e.g., for expansion, and dent that working capital today is worth more the ability to participate in complex transactions. than property ownership over the long-term, and be confident that properties are valued fairly. Net-Lease Finance. Net-lease finance, sometimes called “sell-leaseback,” allows organizations to con- Donating Debt-Encumbered Real Estate to vert their real estate or equipment into working Nonprofits. A new product that effectively cir- capital. Pioneered with aircraft owners in the 1960s, cumvents an IRS prohibition on the donation of the transaction appeals to organizations that have debt-encumbered properties to charities could Strategies and Solutions for Nonprofit Capital Problems Public Policy /33

expand the supply of working, philanthropic capi- inefficient.59 But it is frequently mentioned in dis- tal available to nonprofits. cussions about nonprofit capital for two reasons: Traditionally, only unencumbered properties — for its central role in supplying federal support to e.g., entirely debt-free — could be donated to capitalize affordable housing programs; and for nonprofit organizations. Thornburg Foundation inspiring interest in similar efforts to support other Realty (TFR) has created an instrument that nonprofit programs. allows donors to make tax-deductible gifts of To summarize this important benchmark encumbered properties, potentially “unlocking real briefly: the LIHTC offers federal tax credits to estate, the nation’s largest store of wealth” as a investors who provide equity for the development greater source of capital for nonprofits. of affordable housing. State housing finance The donor of a mortgaged property conveys it agencies usually administer the program — to TFR, which operates a REIT — an instrument awarding the credits, ensuring that projects meet that allows many investors to acquire and own the specified public goals and monitoring long- portfolios of real estate without becoming respon- term compliance. sible for property management. TFR pays off any Developers of low-income housing apply to debt on the property, and issues REIT shares to their state agency for the credits, which are awarded the owner. The property owner then donates its to developers who best satisfy the state’s goals for shares to a nonprofit of its choice. The nonprofit affordable rental housing. When nonprofit organi- then owns shares in the REIT, which will pay zations are awarded tax credits, they sell them to quarterly dividends. investors who, unlike the nonprofits, have federal At least initially, this promising innovation tax liabilities they would like to reduce.60 seems likely to benefit nonprofits that already To create a more efficient market, the National receive gifts of property. If that is true, it seems Equity Fund (NEF) (of the Local Initiatives that neither CDCs nor work-force development Support Corporation) has become a syndicator organizations would stand to benefit significantly. of the tax credits. It raises funds — $2.9 billion to date — from investors through the sale of Public Policy Strategies LIHTCs, and has become a vital element of the If it were not for public policy, CDFIs might be infrastructure. entirely dependent on socially motivated investors; the risks of investing in community development New Markets Tax Credit. This credit hopes to projects might simply be too high for most investors, do for commercial economic development what particularly those who are poorly informed about the LIHTC has done for affordable housing. low-income communities. But a combination of tax Enacted as part of the Clinton administration’s policy and bank regulation has provided new oppor- New Markets program, it aims to leverage up to tunities for generating permanent capital for com- $15 billion in equity investment for community munity development projects. The most cited public development projects and institutions. policies are reviewed below. Investment funds geared primarily to serving low- and moderate-income communities are eligible Low Income Housing Tax Credit (LIHTC). This to apply to the Treasury Department for participa- federal tax credit, introduced in 1986, is the most tion in the program. The funds can be community important federal program for financing the devel- development banks, community development ven- opment of affordable rental housing. The LIHTC ture capital funds, CDCs — or national or regional is no longer novel, and has long been criticized as funds that, in turn, invest in these institutions. Public Policy /34 Strategies and Solutions for Nonprofit Capital Problems

The funds selected to participate are authorized by America’s Private Investment Companies Treasury to allocate credits to investors, who can (APIC). Modeled on the Overseas Private then claim tax credits worth 25 percent of their Investment Corporation, the APIC program uses total investment. The funds (not the investors) government guarantees of debt to leverage creation decide what projects to invest in. of “a new generation of large-scale private investment companies that find and invest in promising Welfare-to-Work Tax Credit. Though wage sub- untapped market opportunities in distressed areas.” sidies like this are not new, a recent innovation Although the proposal failed to win congressional has enabled at least one enterprising nonprofit approval, it remains a notable example of an ambi- venture to use the subsidies as a way to generate tious use of government policy to stimulate invest- working capital. ment in community development. Federal law now provides a tax credit to Investment funds that secure commitments employers who hire long-term welfare recipients. from investors to create an APIC would apply The credit can reduce employers’ federal tax to the U.S. Department of Housing and Urban liability by as much as $8,500 per new qualified Development (HUD) and the Small Business employee. Administration for participation in the program. The Local Initiatives Support Corporation If the application to establish an APIC is approved, and Structured Employment and Economic HUD would award government guarantees of debt Development Corporation (SEEDCO),New issued by the APIC. The government would guar- York — another community development inter- antee two dollars of debt for every dollar of equity mediary, have jointly created EarnFair,a tempo- that investors add to the APIC. rary staffing company. Three features of its design The guarantees are meant to benefit both the enable EarnFair to take advantage of the credit. investors and the government. Deals made by First, it is incorporated as a for-profit (limited the APIC would have favorable returns, in part liability corporation), and could use the credits because of the low cost of the guaranteed debt. to reduce its tax liability. Second, instead of Meanwhile, taxpayers are protected in the event of acting only as a placement agency, EarnFair itself failing investments because every dollar of equity becomes the employer of the eligible worker, con- must be lost before any debt is affected. tracting with companies who use the employee The guarantees would aim to create large as a temporary worker, making it eligible for the investment funds able to finance major job creat- credits. Third, it plans to sell some of the credits ing businesses. Funds would be required to have a to for-profits, who can reduce their tax liability minimum capitalization of $25 million, and each without necessarily hiring any long-term welfare APIC would be expected to conduct nine to recipients. This sale of the credits will provide a 12 large-scale deals. supply of working capital to help EarnFair cover its expenses while it develops its business and Equity Equivalents. Building permanent capital income base. pools of CDFIs is difficult because investors find Employers who contract for EarnFair workers returns on CDFIs too low, or are ignorant of the pay the company a fee based in part on the job opportunities they present. The equity equivalent and the worker’s experience. The fee also covers attracts private capital to CDFIs by applying gov- EarnFair’s case-management services, which will ernment regulation in a new way. provide support aimed at increasing the job reten- The equity equivalent (EQ2) builds on the tion of the newly placed worker. Community Reinvestment Act (CRA), which has Strategies and Solutions for Nonprofit Capital Problems Social Investing /35

required banks to make minimum investments or financial, criteria for selecting companies to invest loans in low-income communities since 1977. For in, often through mutual fund operators that banks that are constantly searching for low-risk establish social standards and select companies that meet them. ways to meet CRA requirements, EQ2 presents a new opportunity. It allows them to receive CRA ➤ Shareholder activism — with no direct benefits to credit not merely for the amount of the EQ2 nonprofits — enables investors to use the powers granted to every shareholder (e.g., to vote for investments they make to a CDFI, but instead for directors and participate in shareholder meetings) up to 50 percent of all the loans or investments to bend corporate policy toward more socially made subsequently with funds that the CDFI was suitable goals. able to leverage with the initial EQ2. ➤ Community investment directly benefits nonprof- For CDFIs, the EQ2 provides capital that its, but is the least used strategy, in large part functions like equity. Pioneered in a transaction because it is newer and because it requires invest- between National Community Capital (a CDFI ing in CDFIs at below-market rates of return. association) and Citibank, and later endorsed by CRA regulators, the EQ2 is a long-term, deeply According to a recent Business Week overview, subordinated loan that functions like equity socially responsible investing, especially through because: mutual funds, has grown remarkably in recent years. Between 1997 and 1999, social investment ➤ It is not secured by CDFI assets; mutual funds grew from $96 billion to $154 bil- ➤ It is fully subordinated (meaning the bank making lion. Over the same period, the amount of all the loan is the last of all creditors to be paid); money under socially responsible investment grew ➤ The lender cannot demand any acceleration of 82 percent, from $1.2 trillion to $2.16 trillion, rep- repayment, unless the CDFI changes its primary resenting 13 percent of all money under profes- mission of community development; and sional management. Some investment analysts ➤ It has a rolling term of 10 years minimum, with credit the rise of technology stocks with part of a yearly renewal option. that tremendous growth. They provide socially responsible mutual fund operators an excellent This is an important innovation for capitalizing opportunity: most are considered socially “clean,” CDFIs. The larger their capital base, the lower as well as profitable.61 their cost of funds, and the lower interest the CDFI can charge. Options for Individual Investors. The dollar volume of social investment is up, and so is the variety Social Investment Strategies of causes investors can support. The original prac- Many nonprofit analysts are looking beyond tice, as far back as the eighteenth century, simply government policy and new finance products to aimed at avoiding the “sin stocks” of companies another source of capital for nonprofits and their that traded in tobacco, alcohol and gambling. The causes: individual and institutional investors. mutual fund strategies made popular in the 1970s “Social investing” refers primarily to three favored progressive policies like environmental strategies aimed at directing private capital toward safety, prohibitions on child labor and equal rights social goals: for gay employees. The newest fund options are conservative, focusing on companies that decline to ➤ Socially responsible investment is the most common offer health benefits to the partners of gay employ- strategy, in which investors use social, not just ees or that have no involvement in abortion.62 Social Investing /36 Strategies and Solutions for Nonprofit Capital Problems

Under the more socially ambitious but finan- Options for Institutional Investors. Govern- cially unimpressive “community investment,” ment policies to encourage “economically targeted investors can invest directly in CDFIs, or in mutual investments” were promoted by the Clinton funds with stakes in a variety of CDFIs. While administration in its early years but never gained conceding that the financial returns are modest, congressional approval. Many advocates of com- proponents of community investment argue that munity development had argued for years that the “benefits at the community level in many cases institutional investors — particularly pension outweigh diminished financial returns, making funds, with billions of dollars under management community investing one of the most satisfying — could supply relatively enormous amounts of and promising venues for socially responsible private capital for community development by tar- investors in the future.” geting only a small share of their portfolios toward The Calvert Social Investment Foundation such investments. Conservatives opposed the con- operates Calvert Community Investments, which cept as mischievous social engineering that would allows individual and institutional investors to force investment managers to violate their fiduci- invest in CDFIs. Calvert offers information on ary responsibility to maximize earnings. over 100 CDFIs online, where investors can learn Absent government inducements or regulation, about the CDFI’s portfolio (housing, small busi- institutional social investment is the province of ness, micro-lending, etc.); geographic area of oper- the socially motivated. Pension fund managers ations; populations served; and assets. Investors are still able, of course, to make investments that can purchase a Community Investment Note in an reflect both financial and social objectives. And amount of $1,000 or higher, choosing a term of social investment proponents are working to con- one, three or five years, and choose a fixed rate of vince institutional investors to channel one percent return between 0 to 4 percent, depending on how of their capital to community investments. But charitable the investor wants to be. Investors can many now view foundations — who have over take a mutual fund approach — investing in a $350 billion in assets — as an appealing source of block of CDFIs selected by Calvert — or, for new capital for social-purpose businesses. Beyond investments of $25,000 or more, make a direct the social screening that many already do, founda- investment in one or more CDFIs.63 tions could devote some of their assets (not just Domini Social Investment, which operates the grant dollars) to social-purpose businesses. largest socially screened index mutual fund, has A number of foundations are experimenting created a new product that combines socially with such approaches. The F. B. Heron Foundation responsible and community investment. The new has made some investments in commercial real- Domini Social Bond Fund is a socially screened estate developments that will bring shopping mutual fund that will be operated under a sub- malls, badly needed retail operators and jobs to management agreement by South Shore Bank, the economically distressed central-city locations. country’s largest community development bank. While the investments may well prove profitable, South Shore will invest up to 10 percent of assets none of the present investors in the real-estate in debt instruments and other investments that deals is, according to one program officer, “indif- directly support and promote community develop- ferent to social concern.” ment. A.G. Edwards, Inc., is developing a “socially The Rockefeller Foundation has established a responsible equity linked note” that also attempts formal program to find and make social invest- to enable nonprofits to benefit by participating in ments. The Foundation’s ProVenEx (for Program investment transactions. Venture Experiment) program “seeks to redirect Strategies and Solutions for Nonprofit Capital Problems Social Investing /37

private capital, knowledge and innovation in ways to ensure that the poor and excluded have access to the benefits of globalization.” It invests in early or expansion-stage companies, or in public-private joint ventures in areas that reflect the Foundation’s philanthropic priorities in education, health and inner-city employment.

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Clearly, the appeal of private capital access is enormous. But its real potential for nonprofits may be somewhat restricted. Many of the funds provide permanent capital for community development organizations to invest in the economic development of their target areas, without necessarily satisfying their own need for nonprofit working capital. To meet the nonprofit capital challenge in its entirety will therefore likely require more than access to private capital. The best approach will probably draw on several of the strategies reviewed in this paper.

Reflections /39 Concluding Reflections 4

FTHISPAPERREPRESENTS A MAP OF SORTS that describes the nonprofit capital landscape, it will be difficult to draw a single key lesson from it. IDifferent parts of it will have different values depending on where it is the reader is trying to go. But it’s fair to assume that anyone who has actually pored over this whole map has an interest in understanding and advancing the dialogue about nonprofit capital. These brief concluding reflections therefore focus on that dialogue, and how it might be improved to generate yet more effective responses to nonprofit capital problems. Focusing the Dialogue. The idea that different nonprofits need different types of capital for different purposes is almost self-evident. Yet the general discourse among both nonprofit managers and funders seems to make few of these distinctions. It might be helpful, therefore, to develop a more refined assessment of the capital needs of any given nonprofit, or class of nonprofits. Drawing on the simple distinctions offered in part two of this paper — about facilities, working and permanent capital — it would be fairly easy to characterize the overall capital position of a nonprofit, or a group of similar nonprofits. Some nonprofits will have intense capital needs: they might be in competitive markets that require capital; need improved facilities to offer quality services; deal with capital-intensive development programs; and perform so well that investing in their capacity for effectiveness will likely pay off. But most nonprofits do not need capital on all these counts. We can be more focused — by industry, by organizational profile, by market position — in contemplating solutions to capital needs. It’s not enough to talk about “nonprofits,” “funders” and “capital.” Broadening the Dialogue. Paradoxically, it seems that we need to broaden — as well as focus — the dialogue about capital. The leaders, managers and proponents of each of the four strategies mapped in this paper seem to inhabit quite separate worlds. Those working on access to the private capital markets have amassed extraordinary expertise, which has been deployed mostly in the community and economic development arena. Many of their finance strategies, however, could be of great value to the broader field. At the same time, those working on reforming philanthropy are not explicitly targeted at community development. Yet they have developed insights and practices that could address one of the great challenges Reflections /40 Deepening the Dialogue

facing nonprofit economic development organizations: how to invest in organizational capacity that produces results. More traffic among the proponents of various strategies could give everyone a stronger conceptual and practical base for serving their missions. Deepening the Dialogue. At the risk of presenting a baffling image of this proposed dialogue, one more feature should be added: depth. It seems that the more we have developed consensus, capacity and sophisticated innovation on any of the capital strategies, the further we get from the underlying assumptions and rationales for them. To take an example hinted at in the discussion about reforming nonprofits: We have a broad consensus about the need for nonprofits to become self-sustaining social enterprises, and about the benefits that strategy confers. Yet revisiting some of those assumptions might stimulate yet more creative responses. Are we really living in an age of scarcity — with declining government and philanthropic funding — that requires self-sufficient nonprofits? Is extending the discipline of the market the only framework for thinking about nonprofits’ impact? Couldn’t we develop, for instance, a capital framework that is built on the discipline of market failure — identifying and giving priority to exactly those areas where the market, and public funding, do not reach effectively? Each of the strategies in play today is built on deep layers of assumptions. While we’re busy with technical innovations, it might be productive to revisit those assumptions and question them, so as perhaps to become inspired by new problems and possibilities.

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Even if we thought a more focused — yet broader and deeper — capital dialogue were valuable, how would we achieve it? It would be foolish to attempt to engineer such a comprehensive approach to a problem so broad that it belongs to everyone in the nonprofit sector. Instead, it would probably do if more of the innovators and proponents of the various capital strategies continued to work in their chosen areas but occasionally crossed their boundaries into nearby territory, which this mapping exercise may facilitate. Nonprofit Capital: A Review of Problems and Strategies Related Readings /41